Why Do Investors Fear ARMOUR Residential More than Annaly?

ARMOUR Residential's large discount to book value is driven by a variety of factors that explain why the market has comparatively more confidence in Annaly Capital Management.

Jul 14, 2014 at 5:59PM

Source: Company

Investors in mortgage REITs learned a valuable lesson in 2013: Do not only focus on the dividend yield when you need to decide about your income investments.

And investors in ARMOUR Residential REIT (NYSE:ARR) certainly learned that lessen the hard way as its book value per share and its share price fell off a cliff in 2013 in light of a more restrictive monetary policy of the Federal Reserve.

Mortgage REITs have been extremely attractive investments over the last five years when low interest rates and a collapse in the housing market fueled speculation in residential mortgage-backed securities.

Mortgage REITs take on pretty large amounts of debt and invest their short-term funds in long-term mortgage securities. This is a risky business model, which has worked well from 2008-2012, but it relies on favorable market conditions for leveraged investment strategies, namely low debt costs and the availability of leverage.

Mortgage REITs disappointed investors in 2013
Investors made a crucial mistake as 2013 come around: They solely bought mortgage REITs such as Armour Residential or Annaly Capital Management (NYSE:NLY) because they chased their double-digit dividend yields, but didn't factor in underlying book value declines as a result of increasing long-term interest rates.


Source: Company

Mortgage-backed securities are immensely complicated investment structures, but rising interest rates (implying higher interest rate volatility) will reduce the value of investment portfolios that are largely invested in mortgage-backed securities.

Though ARMOUR Residential's dividend yield, which has stayed at the upper end of the yield spectrum at 14% for a long time, was appealing to investors, the total return really does not look that great.

Even though investors may have benefited from a 14% dividend yield, this seems like a rather poor return considering that ARMOUR Residential's shares actually lost 38% in 2013.

Shares of Annaly Capital Management lost 29% of value, but the market seems generally more optimistic about the industry leader than ARMOUR Residential.

Book value discounts
As can be seen in the chart below, Annaly Capital Management consistently traded at lower discounts to book value compared to ARMOUR Residential over the last year.

Presently, ARMOUR Residential trades at a 17% discount to its first quarter 2014 book value per share of $5.23 whereas Annaly Capital Management trades at a 9% discount to its Q1 2014 book value per share of $12.30.


And the reasons for the apparently more negative attitude of investors with respect to ARMOUR Residential are quickly identified: High leverage ratios, ongoing book value declines and a less reliable dividend record all contribute to ARMOUR Residential's comparatively large discount to book value.

1. Leverage
ARMOUR Residential has generally had high leverage ratios in the past. At the end of the first quarter of 2013, ARMOUR Residential reported a leverage ratio of approximately 9:1. Fast forward one year and ARMOUR Residential has brought down its leverage ratio a bit to around 8:1.

Though investors have seen a slight decrease in indebtedness, leverage ratios are still relatively high particularly considering that many mortgage REITs have largely de-risked their balance sheets in 2013.

Annaly Capital Management, for instance, reported a leverage ratio of 5.2:1 in the most recent quarter and a ratio of 6.6:1 in the first quarter of last year. In other words: Compared to ARMOUR Residential, Annaly Capital Management is significantly lower leveraged and also de-risked faster than ARMOUR Residential.

2. Doubts about the stability of ARMOUR Residential's book value
The second reason for the valuation discrepancy between these two mortgage REITs relates to their different book value developments. While Annaly Capital Management reported a slight sequential increase in its book value in the first quarter of 2014 to $12.30 per share, ARMOUR Residential reported another sequential decline in its book value per share from $5.32 to $5.23 in the most recent quarter.

Investors are highly skeptical of mortgage REITs, that have not yet stopped the bleeding of book value. Declining book values may foreshadow dividend cuts and investors don't hate anymore than cuts in their distributions.

The market still has doubts about ARMOUR Residential's book value stability. A return to sequential book value growth, however, could be a catalyst for ARMOUR Residential's stock.


3. Dividend record
Last but not least, dividend records play a large role in the different perception of the two mortgage REITs. Annaly Capital Management pays investors regularly since 1997 and is a industry-leader that carries some weight in the marketplace. Put differently: Its dividend record has much higher credibility than the one of ARMOUR Residential which pays investors only since 2010.

A reliable dividend record over a variety of business cycles carries a lot of value when investors question underlying book values and the future profitability of the companies involved in the sector.

Looking ahead
Higher leverage ratios, ongoing book value declines and a shorter, less reliable dividend record are the reasons why investors correctly perceive ARMOUR Residential as riskier than its larger mortgage REIT rival Annaly Capital Management.

Both mortgage REITs still suffer from a loss of investor confidence due to a series of dividend cuts and book value declines in 2013. Annaly Capital Management, however, gets the benefit of the doubt whereas ARMOUR Residential will have no other choice but to prove itself in 2014.

Boost your investment income today
Our top analysts put together a report on a group of high-yielding stocks that should be in any income investor’s portfolio. To see our free report on these stocks, just click here now.

Kingkarn Amjaroen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.

Compare Brokers